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REPOSSESSION OF LEASED ASSETS: AN INTERNATIONAL PERSPECTIVE

by Steven Gilyeart, J.D.,

Steven Gilyeart is an internationally acclaimed authority on leasing law, and is a consultant on leasing legal problems to firms and governments across the World. Steven Gilyeart runs a website on leasing The International Leasing Resource which is a wonderful storehouse of information.

The Importance of a Repossession Capability

One of the reasons financial leasing has been so successful is the stronger set of rights and protections provided the lessor as the owner of the leased asset compared to the rights and protections given the traditional bank lender who takes an interest in collateral, whether by non-possessory pledge, chattel mortgage or security interest. Just how much stronger those rights are depends upon a number of factors, including not only the provisions in the law, but the judicial environment of the country, the terms in the lease contract and the culture of the marketplace. This article will examine some of those aspects.

Form v. Substance

Just as with tax systems and accounting standards, the “form v. substance” issue is an important analytical starting point for the examination of legal issues, including the issue of repossession. In some countries, it is enough that the transaction in question is documented as a “lease”, has the “lease” word running rampant through the paperwork and in its form appears to be a lease. No further examination beyond the surface indices of the transaction is made. This approach is taken in almost all countries when leasing first appears, but can continue long after the leasing industry has become established in countries with a civil law tradition or countries transitioning from a socialist legal structure. Countries with civil law traditions exist in Continental Europe, Latin America and parts of Asia, such as Indonesia. Most of Eastern Europe, Russia, China and parts of south-east Asia are also resurrecting, at least in part, older civil and commercial codes that have their roots in the civil law legal traditions of western Europe, as they move from command-and-control economic systems to more market-oriented economies. Countries with common law legal traditions, however, tend to take more of a “substance” approach to examining leasing legal issues. Common law legal traditions dominate in those parts of the world where the British Empire once held sway: England, the United States, Canada, Australia and New Zealand.

The “form v. substance” distinction is critical for determining just what bundle of rights and remedies a “lease” creditor has in the case of a “lessee” default. Under a form analysis, almost any creditor who, with a straight face, can call himself a lessor, is one, and will receive all the legal benefits of that status. On the other hand, under a substance analysis, it does not necessarily matter what the parties call the transaction or what labels they attach to themselves. If the economic substance of the transaction is indeed that of a loan rather than a lease, the law will consider it a loan and provide the so-called “lessor” with only that set of legal rights and remedies that are provided a lender with an interest in collateral of the borrower. Almost always, the lender’s set is impoverished compared to that of the real or true lessor. This is true both in regular court enforcement proceedings and in bankruptcy or other insolvency forums. And it is also generally true in those civil law systems that have yet to decide whether or not they are taking a form or a substance approach to leasing or other commercial matters that create similar consequential issues, although civil law approaches can create other significant problems for a lessor. Life is not necessarily simplified because the “form” label can be attached to the judicial approach.

[For more on Form versus Substance of a lease, read Vinod Kothari’s article on True leases by clicking here.]

Ownership May Be a “Real Right” But Possession Is More Than 9/10ths of the Law

Repossession is supposed to be easier for a lessor than is foreclosure of a collateral interest by a bank lender because of the lessor’s ownership of the asset. However, it does not always work that way.

There is an old saying that “possession is 9/10ths of the law.” The translation goes: “although the law is on your side, good luck in trying to get something of yours away from someone who has wrongfully taken or kept it.” Yet, the way the law is written in some countries with a civil law tradition, not just the practical realities and difficulties of recovering something of yours that is in the hands of another get in the way, the law itself may protect the other side for no other reason than that they have the current possession of the (your) property.

In the civil law tradition, ownership is a “real right” accorded specific recognition. It is a basic, fundamental right laying at the root of the property rights system. However, just as in the common law, possession can be separated from ownership and can carry its own set of privileges. In the common law, a transfer of possession transfers a “subset” of rights that is more or less “smaller” or “inferior” to what the owner had. In the civil law tradition, possession does not necessarily confer a subset or inferior set of rights but a “different” set that can exist at a parity with that of the rights accorded “ownership.” As a consequence, ownership by a lessor may not put the lessor in a position superior to that which the lessee has by way of possession. If a lessor aggressively repossesses the asset in such a situation, the lessee may not only be able to make a claim against the lessor for damages but may itself be entitled to a self-help recovery remedy against the lessor which was denied to the lessor against the defaulting lessee! Macedonia, which derives its legal heritage from the Austrian civil code, has just such a situation in its most fundamental property rights law. Possession “trumps” ownership–not a good situation for a lessor nor for the development and expansion of the leasing industry.

Self-Help Repossession

The phrase “self-help repossession” is a reference to the action of the lessor in simply going to the lessee and taking away the leased equipment, with or without the lessee’s consent, upon a lessee default under the lease contract. The lessor usually bases the right to such action upon a provision in the lease contract which expressly gives the lessor the right to do so. Whether local law supports such a contract provision, prohibits its or is silent about it, is a different issue. Without one or the other of a contractual basis or a provision in the commercial code or other applicable law, a lessor may be ill-advised to take such action. Of course, the most basic justification is that as the owner of the assets leased by the lessee, it is the lessor’s own property that it is recovering. And this may be enough under some legal systems, especially those that are somewhat “rudimentary” or in the early stage of their transition from a formerly different political/economic/legal environment, as is often the case in transitioning socialist systems. Such countries do not have a very substantial body of law yet developed, particularly as regards the relatively sophisticated implications of financial lease transactions. Yet, in more developed legal environments the law will have something to say about the issue.

Legally-Empowered Self-Help Repossession

In some countries the law specifically provides an endorsement of a lessor’s ability to proceed with self-help repossession efforts upon a lessee breach of the lease agreement, so long as such effort will not create a “breach of the peace.” This means that the lessor must “back off” and resort to the courts if the lessee presents an active resistance such that a fight, a forced entry, a trespass that could result in violence or even a threat of violence, might occur. “Breaking and entering” or other conduct that would normally be a crime is not allowed, even if the contract would seem to give the lessee’s consent to it. Yet, a contractual provision allowing for repossession upon default may not be required if the law itself provides for self-help repossession. The Uniform Commercial Code of the United States provides just that for not only leases but for traditional loans with collateral and conditional/installment sales as well. Nevertheless, it is always far better to have such authorization clearly set out in the agreement between the parties themselves,i.e, in the lease agreement, than to rely solely upon the statute.

Non-legally Empowered Self-Help Repossession

In most civil law countries, and in Louisiana in the United States, which bases its laws upon the Napoleonic Code, self-help repossession is not provided for in the law. That does not necessarily mean that it is prohibited but rather that the law does not provide an authorization for it. In such a country a lessor with a self-help repossession clause in its lease agreement may have sufficient legal authority to take action. However, the usual situation is less clear. Depending upon the language of other provisions in the civil or commercial code, the provisions of the statutes may work together in such a way as to in effect bar self-help repossession. For example, the protections afforded one with a possessory right as discussed above may create such a right for damages for interference with that possessory right that repossession is not viable, even by one with an ownership right. Other times, a restraint on self-help repossession may be deduced from the overall tenor of the code and the perception that a self-exercised remedy would be severely frowned upon by any judge ultimately involved in the matter.

Yet, in many countries, especially those with a less developed judicial system, and particularly those where the courts are not effectively functioning, lessors are inclined to help themselves, sometimes with the assistance of “strongmen.” These lessors rely upon their contract language and their ownership position in justification of their action if such matter should ever end up in court. In such circumstances, lessors are inclined toward aggressive action because the reality is “either the repossession remedy or no remedy.”

“But I don’t want it back!”

Even if the lessor does recover possession of its leased asset, it may not be enough. There may be no secondary market for the asset and no ability to sell it for any sum that would come close to “making the lessor whole.” This is usually a significant problem in emerging lease markets, enough so that many lessors do not want the equipment back, even in a default situation, and have complained bitterly about judges who have ordered the equipment’s return. Of course, the complaint is really about the “credit” that is given the lessee on its total lease bill for the “value” of the leased equipment. Even though there is no secondary market, judges in such circumstances have been known to give equipment an arbitrary and artificially high value, often wiping out the lessor’s claim for any further monies from the lessee. This has been one of the problems for lessors in China.

The functional usefulness of repossession as a real tool for a lessor faced with a lessee default in an emerging lease market where there is no realistic secondary market for used equipment of the type leased is a problem that goes beyond the ability of legal contracts to solve. This does not mean that lessors should omit repossession provisions from their contract but rather that they must be realistic about what it will do for them. It may not make them money. Sometimes it may do nothing more than allow them the ability to deprive the lessee from use of an asset for which they are not paying. Yet, that alone may have significant value and may be a strong factor in encouraging the lessee to make those periodic lease payments. In fact, in economies without an adequate secondary market, that is the main value of a repossession capability–and that value should not be underestimated.

Moreover, the secondary market will ultimately develop, even if the development occurs in fits and starts. Vehicles usually lead the way, along with or followed by heavy equipment; office equipment tends to bring up the rear. This is one of the reasons why it is prudent for governments wanting to develop the leasing industry in general to not disparage the leasing of vehicles. Leasing needs strong secondary markets. Once leasing gets past the stage of being nothing more than a “disguised loan or installment sale” and the leased assets are being returned to the lessors, leasing begins to “manufacture” used equipment as part of its production process. This used equipment is not a “by-product” but an integral part of the leasing business. And strong returns on this product will allow for lower lease payments to the lessee, which translates at the macro-economic level to a lower cost of capital for business. (Remember that as a lessor’s residual position increases, lease payments go down. A decrease in a lessor’s residual position will increase lease payments.) Because of their generally high residual value and readily marketable character, vehicles are the unsurprising leader is conditioning the marketplace in general to accept used goods and to create venues for their sale and purchase.

Judicially-Assisted Repossession

Post-Judgment

Most judicial systems have a mechanism for compelling the return of assets to their rightful owner, at least after a judicial conclusion of the case.. This is true for common law and civil law systems alike. Modern socialist systems may or may not have yet enacted laws that make the process “easy,” although the civil and commercial codes are structured and written in a way that accommodates such judicial assistance in principle. However, the reality is that the delays of the judicial process are often so great that if the equipment is indeed ultimately returned after the pronouncement of a judgment and the effort taken to enforce it, the equipment has so declined in value that the recovery is economically meaningless. Additionally, the present value of the funds realized upon such delayed disposition of the asset makes the effective recovery even worse. This situation is aggravated even further by the common circumstance that countries with marginally functioning judicial systems with lengthy inherent delays often have significant levels of inflation, making for an exacerbated decline in that present value.

Pre-Judgment

Fewer legal systems have a process for pre-judgment return of assets to a claimant making a challenge against the one currently in possession. Common law systems are better in this regard than are many civil law systems. The existence of such a pre-judgment, “summary procedure” can provide a big boost to the development of the leasing industry within a country, as it makes judicially-assisted repossession a practical and effective tool. Even in countries with a strong self-help heritage, the value of a judicially supported repossession process has been proven. In fact, the existence of the judicial resort usually encourages cooperation by defaulting lessees and can promote uncontested repossessions. Breaches of the peace are avoided, lessors get an early recovery of the asset that they own, the courts may not have to be involved, and a lessee who feels that the repossession was wrongful under the circumstances can still make a claim for compensation against the lessor.

In civil law systems that do support pre-judgment property recovery, the presumptive validity of the lessor’s claim of entitlement is often supported by the fact that the lease contract has been notarized. Notary systems are a hallmark of the civil law tradition and provide a verification function for a variety of “public acts.” In some civil law countries, a contract must be notarized to be valid and enforceable. Even if notarization is not such a requirement, it can still be a good idea to have the lease contract notarized. Notarization creates a strong presumption of contract validity, sometimes a conclusive one. These notarization structures can provide a foundation supportive of judicially-empowered repossession. In other words, if the lease contract is notarized, a lessor should be entitled to a court order on short notice that authorizes its repossession and directs assistance from local law enforcement authorities if necessary.

Pre-judgment, judicially-assisted repossession can also be supported in some countries that have lease registries. If the lease is registered, the lessor should be entitled to a summary repossession procedure. While relatively few countries have lease registries, more are considering them. Of course, it does not follow that the repossession right be conditioned upon registration. Rather, the registry, as in the case of notarization, can be used to provide a “boost” to a process that may not have been traditionally recognized by the existing judicial system.

Without a doubt, the most effective registry is the Uniform Commercial Code filing system in the United States. While being directed toward “secured transactions,” i.e., loans with collateral and conditional/installment sales, it accommodates registration of leases as well. Although registration is not a prerequisite to judicially-assisted repossession in the United States, the legal environment for leasing has developed differently there than in emerging markets and repossession activities are effective without such support. Yet, regardless of how it comes to pass, effective repossession processes, both judicial and extra-judicial, are necessary for the healthy development of a domestic leasing industry..

Repossession and Arbitration

To avoid the problems and delays arising from utilization of local court systems, it has become increasingly popular for commercial parties to include arbitration clauses in their contracts. This practice is well-established in cross-border lease transactions and is supported by theConvention On the Recognition and Enforcement of Foreign Arbitral Awards (New York, 10 June 1958). Most, but not all, of the world’s countries have ratified this Convention. (Click for list of countries.) While this Convention works well with large, established multinational companies, it may be more problematic with medium and small-sized enterprises. The theory is good but the practice diverges.

Similarly, a number of countries, including a number of the modern socialist states, have adopted arbitration acts for use in resolution of their domestic disputes. While a reading of these laws can make one conclude that all is now well, the reality is often quite different, with arbitration simply replacing the problems of court proceedings with a new set of problems all its own. The situation is often even worse, as the arbitration award usually has to be registered with the court and the enforcement mechanisms are the traditional judicial ones. Moreover, many arbitration acts provide or contemplate that all arbitral awards will be made in money. There may be little authority for an arbitrator to direct and require the return of a specific item of property, such as an order to return the leased equipment to the lessor.

The Trend in Repossession Activity

It may be incredibly ambitious to talk about a “trend” in repossession activity; if there is one, it is modest and barely discernible–but it may be there. While that trend is toward a more “repossession friendly” environment, it is for different reasons in different markets.

Leasing has become well recognized by the World Bank, the Asian Development Bank and other multilateral development agencies as a useful and practical tool for accelerating development of capital markets in emerging and transitioning economies. It is a critically important financial tool in the small and medium sized enterprise (SME) sectors of these economies, and it is usually from the SMEs that growth in the national economy occurs–it does not come from the large, moribund state-owned businesses. An SME that cannot qualify for a bank loan, may be able to obtain a lease, because “ownership of the asset gives the lessor strong security. …leasing offers the advantage of … simpler repossession procedures, because ownership of the asset is already in the lessor.” (Leasing in Emerging Markets, IFC, 1996), p. 3.) Yet, to make that incentive effective, the repossession laws must really work. As a result, when financial leasing laws are proposed for these countries, attention to deficiencies in repossession processes is an important element of the proposal.

In mature markets, almost by definition, the courts are functioning adequately and the business community has reasonable expectations surrounding return of equipment that is not being paid for. While there will always be the infuriating lessee who just refuses to cooperate not only with the lessor but even with the courts, the problem is not systemic to the industry as a whole. This orientation toward cooperative return of the equipment is also being supported by the trend in shorter lease terms, with a focus on upgrades, rollovers, substitutions, and other more “service”-oriented product elements. Unlike the lessees in an emerging market who have the mind-set that they are “buying it” and that the leased equipment “is theirs,” lessees in more mature markets want to have less and less to do with the equipment and want lessors to provide more and more services in the care, management, and replacement of it. “Take the equipment, please.”

Concluding Comments

The capability to repossess the leased assets when the lease is in default is an important risk mitigation tool for not only an individual lessor but for the development of the leasing industry itself. On a world-wide basis, the legal and judicial support for repossession activities lacks much to be desired.. Yet, it is ever so slowly getting better.